Portfolio Management 101 > GPM > Portfolio Strategy – Is it Time to Dip a Toe Into Oil?

Portfolio Strategy – Is it Time to Dip a Toe Into Oil?

The decline in the price of oil has occurred rapidly and has shifted the balance of power and wealth back to countries that are net consumers of oil after many years of accumulating benefits to countries that are net exporters. For several years, article after article was written about how the emerging economies were poised to surpass those of the developed countries due to the growth of the middle class, higher productivity, and GDP growth that was oftentimes twice that of the developed world.

But now that oil prices are at a multi-year low, the balance of power has shifted back to countries that are net importers of energy. Countries such as the United States, China, Germany, etc., are net importers of energy and with lower oil prices, inflation in these companies can remain low and the consumer will have more money to spend elsewhere. On the other side of the coin are net exporters of oil that are facing fiscal challenges and social unrest as their oil revenues have plummeted. Despite being lower cost producers than the U.S. and still being able to produce oil at a profit, many of the oil exporting countries rely on oil revenues to fund their government spending and decreases in price affect revenues, even if oil production is still profitable.

Crude Awakening

The decline in the price of oil has certainly benefited the U.S. consumer, which is expected to have higher levels of discretionary income as a result of lower gasoline prices. As the price of oil has declined, the price of gasoline has followed, with the price difference on a per gallon basis typically within the $1.00 to $1.40 range. Some estimates put the gas savings for U.S. consumers at $300 billion.

US Gasoline and Crude Prices

Whether the consumer spends those savings or socks it away for a rainy day is yet another topic of much debate as are the guesses of what the consumer will spend the extra discretionary income on. Thus far, U.S. retail sales have been disappointing even though the equity prices of many retailers has spiked. Instead, the savings rate has inched higher over the last few months and there has been an uptick in spending on restaurants and services. Instead of opting to buy ‘stuff’ with the savings from gasoline, consumers are spending on ‘experiences’. This is consistent with the Permanent Income Hypothesis we wrote about last week in Consumer Spending Won’t Rebound Until Income Becomes Permanent. It is also well-known that lower gasoline prices benefit the economy with a lag and the price decline was so rapid those savings may not have had time to flow through the system and become part of the consumers new psyche.

That the price of oil declined should not be that big of a surprise, however, even though I too was certainly caught off-guard. Production of oil in the US has been expanding for years and other countries like Iraq and Libya have both increased production in recent years. Combine that with the economic slowdown in Europe and China, plus a stronger dollar, and you have both an increase in supply growth at the same time that demand growth is slowing. As of the end of 2014, global supply of oil had reached over 94 million barrels per day, and you can see the big spike in supply beginning in early 2013.

World Oil Supply

As I mentioned earlier, much of this increase in supply is attributable to the increased production in the U.S., which has increased more than 3 million barrels per day, coinciding closely with the increases in global supply from just below 91 million barrels to 94 million barrels.

US Field Production of Crude Oil

Source: U.S. Energy Information Agency

But the supply and demand curve isn’t as out of whack as you might think considering the collapse in oil prices. I believe the market is pricing in a much higher supply glut at the moment, and while inventory levels have certainly increased, a supply disruption could jerk the market off-balance again.

World Liquid Fuels Production and Consumption Balance

But with inventory still at high levels, it could require a prolonged supply disruption or and considerable spike in demand for prices to increase rapidly from here. That being said, the ‘peace’ in the Middle East has enabled supply to flow uninhibited. And I don’t want to sound naïve or discount the tensions and issues the region faces, but I can’t remember when there was a meaningful disruption in supply due to violence or threats of violence. Are we due?

What has been surprising is the speed at which oil prices declined, particularly when supply growth due to the U.S. shale revolution has been so well-documented. For reasons that will always baffle me, it seems the entire market was guessing that OPEC would cut production, if, for the simple reason that they have done it in the past. Interestingly, and painfully for some, OPEC did not reduce production in what industry experts claim is a shot over the bow of US shale producers. Some might even argue it is more than a warning and that OPEC is trying to drive some U.S. shale producers out of business.

So what happens from here now that we know OPEC is serious about maintaining market share at the expense of lowering its own revenue and to the detriment of less efficient U.S. producers?

Oil Price Forecast

According to EIA, Brent crude prices will average $58/bbl in 2015 and $75/bbl in 2016, with WTI prices $3 and $4 below those of Brent, respectively. However, the level of certainty of these price forecasts is very low, which is leading to a wait-and-see attitude by most investors. The WTI Crude Oil price chart below indicates a steady increase over the next two years but the green dotted lines above and below the STEO price forecast is indicative of a very wide range of possible outcomes.

WTI Crude Oil Price

Supply/Demand – So what will cause prices to increase now that we know what caused prices to decline? Well, U.S. production is expected to continue to increase despite attempts by OPEC to force US producers to slow production. US crude oil production averaged an estimated 9.2 million barrels per day in January 2015, and forecasts are for production to increase to 9.3 million bbl/d in 2015 and 9.6 million in 2016. This would be close to the highest annual average level of production in U.S. history, which occurred in 1970. So while U.S. production increases have been part of the driver of higher supply and lower prices (lower demand also contributed), it doesn’t seem that a decline in U.S. production will be the catalyst for an oil price increase.

However, according to Rystad Energy, there are three main effects of lower oil prices on the supply of oil that could play out over the next few years:

  • At $50 per barrel, up to 1 million barrels per day would be reduced in the next 2-3 years due to a reduction in infill drilling both onshore and offshore. Infill drilling is the addition of new wells in an existing field used to accelerate recovery. In the event of lower oil prices, accelerated recovery will be less beneficial and very likely to be reduced. Instead, producers will be inclined to wait until prices increases again before increasing recovery rates.
  • Reducing rig count. According to data compiled from Baker Hughes, rig count has decreased from close to 2000 to 1267 in a matter of 4 months is expected to continue to decline. It is not likely that rigs will be shut down, but rather, as wells are depleted, new wells will not be drilled and new rigs will not be deployed.
  • Reduced CAPEX spending – with the decline in oil prices, projects that were profitable only at higher oil prices will now be postponed, causing capex spending to decline. The decrease in capex spending due to lower oil prices is estimated to be reduced by $150 billion in 2015 alone.

Meanwhile, the growth rate of demand for oil has declined from almost 14% in mid-2009 to around 2%. Much of this decline can be blamed on the slowdown in growth within emerging economies such as China and Brazil, whose economic growth is a much bigger driver of energy consumption than for comparable GDP growth in more developed economies.

The chart below compares the GDP growth of Non-OECD countries to the consumption of liquid fuels. The period from late 2008 to 2010 coincides with GDP growth rates above 6% while oil consumption growth rates reached almost 14%. Since then, both GDP and oil consumption growth rates in Non-OECD countries has been in decline, with GDP hovering around 4%.

Economic growth has a strong impact on oil consumption

Key Indicators

There are many indicators we can look at to extrapolate the future price movements of oil as well as tangential data that can indirectly lead to certain conclusions. Besides production and consumption data that I have already mentioned, there are other indicators that could aid in identifying opportunities in the energy sector.

  • Oil Inventories – The level of oil and petroleum product inventories has continued to climb throughout 2014 and is now at a level approaching 2 billion barrels, with oil making up about 300 million of the total. This has led to an increase in storage capacity of 60% compared to 48% at the same time last year and these estimates are understated because estimates are not available for floating storage, tank bottoms, and barges.

US Crude Oil Inventories

weekly us ending stocks of crude oil and petroleum products

  • Refinery Utilization – refinery utilization is currently at 86.6%, which is above the 5-year average but down from 94% at the end of 2014. With the spread between gasoline prices and crude prices (i.e. refining margins) at the low end of the $1.00 to $1.50 range shown in the chart above, it is likely that there could be earlier refining maintenance shutdowns resulting in utilization rates falling even further despite this being the time of year that refinery utilization begins to ramp up again.

US percent utilization of refinery operable capacity

My bet is that refinery utilization in 2015 will continue to decline throughout the first 3-4 months before ramping up for the summer months and it is unlikely to reach the 95% level it reached in the Summer of 2014 unless oil prices recover considerably.

Refinery Utilization

Investing in Energy

It’s not easy to invest in a sector when it is the topic of many headlines and one of its biggest drivers can be manipulated by economic policies. It is even more difficult to go against the consensus opinion to wait until oil prices stabilize to jump back into the oil sector. But history has shown that contrarian investors with sound judgment and patience can be rewarded over long periods of time. To invest in energy today would certainly constitute a contrarian play, but it may be one worth making.

In December of 2014, $3.2 billion went into exchange traded funds that held positions in Exxon Mobil (XOM), Schlumberger Ltd. (SLB), etc., even as oil prices continued to plummet.

Whether these investors were early to the party is hard to tell. Even now, while oil prices seem to have stabilized a bit, there are some experts that claim there is still another leg or two down in oil prices before it begins its widely predicted ascent by the end of 2015.

The long-term price of oil is expected to be higher than it is today due population growth, the expanding middle class of the emerging markets, and several other secular trends. The difficult task for the investor is trying to time the bottom, and as you’ve heard me say many times before, market-timing is a fools game. In the short-term, impatient investors may lose a bit more hair and lose a little sleep, but the general consensus is that oil prices will be higher in the long run. So why not stick a toe into oil?

Finding Opportunities Along the Value Chain

There are several sub-sectors in the S&P Energy sector but for simplicity, I will divide up the value chain into upstream, midstream, and downstream. While the entire energy sector is cyclical by nature, the impact of certain drivers on each area of the value chain can differ significantly throughout the business cycle. For example, when oil prices are low, downstream companies may benefit from lower oil prices, which are the inputs to their production processes, such as refining. While higher oil prices may benefit upstream companies because they are able to expand margins on what is typically a fixed drilling cost.

The biggest losers in the most recent decline in oil prices have been the oil services providers that offer services to the exploration and production companies upstream. As E&P companies have shut down wells and reduced capital spending, the need for drilling equipment and other services has declined. Meanwhile, the midstream transportation companies have been impacted less by the drop in oil price, because the demand to transport it has remained high as oil demand continues to grow. Midstream companies are typically only negatively affected when demand for oil and gas decreases. That has not been the case.

Depending on your investment objectives and risk tolerance, I will provide three alternatives to investing in the energy sector, and specifically, the oil and gas sector. This doesn’t mean you can’t invest in all three, but I will highlight an opportunity for each of the three investment objectives: wealth preservation, income, and growth.

Wealth Preservation – Exxon Mobil

If taking a conservative approach to investing in the Energy sector, I suggest focusing on the mega cap integrated multi-nationals. Exxon is the second largest company in the S&P 500 index behind Apple (AAPL) and has global operations ranging from upstream exploration and production to downstream marketing (gas stations). It is probably the most efficiently run company among its peers and boasts higher margins and higher returns on capital than its peers. Despite recently reporting a 21% decline in earnings from the prior year period, Exxon Mobil is positioning itself to benefit from wider margins in the liquids segment (compared to gas) by changing its product mix, and has the profitable chemicals business that has thus far helped earnings.

Because of its complementary integrated businesses and its ability to implement those efficiencies, the volatility of earnings and stock price for Exxon Mobil is less than its peers. It also boasts the highest ROE and ROA among its peers as shown below. If you’re a retiree or otherwise are looking for a way to play energy without taking on too much risk, Exxon Mobil would be a good choice.

Exxon Mobil Peers2

Income – Enterprise Products Partners LP (EPD)

EPD is probably one of the most well-run master limited partnerships in the industry and owns very high quality assets. As we mentioned earlier in the article, midstream companies aren’t as affected by lower oil prices so long as demand remains strong. Enterprise’s assets are very tightly integrated allowing it to quickly adapt to changes in demand without adversely impacting costs while also having the flexibility of serving both the oil and gas and petrochemical producers. Enterprise pays a nice dividend of 4.5%, which although is below its top competitor Energy Transfer Partners (ETP), is still quite attractive. In my opinion, it is a much stronger company with a more favorable risk/return profile than its peers.

EPD Peers2

Growth – Ring Energy (REI)

I wrote a detailed article about Ring Energy back in October 2014. Unfortunately, the article was written while WTI oil prices were still in the $80’s and price forecasts were for oil prices to increase from there. We all know what has happened to oil prices since then and prices of energy stocks across the board have collapsed by more than 40% in some cases. It has been painful to watch but nevertheless, I bought more Ring Energy stock in the $9 range because I still feel that there is substantial upside in the stock.

The company has recently pulled back on some drilling due to lower oil prices but production continues to expand at a rapid pace. In the 4th quarter 2014, REI produced 155,100 BOE’s compared to 64,000 in the same quarter last year and 140,000 in the 3rdf quarter of 2014. The gross acreage in the company’s Texas properties also increased from 14K acres to almost 30k acres. And because of the drop in oil prices, management is seeing attractive acquisition opportunities. So for a patient investor, the long-term potential is significant.

For more information on Ring Energy, I suggest clicking on Ring Energy: Digging for Black Gold in All the Right Places

It’s not fair to compare a small independent oil and gas exploration company with the larger, multi-billion dollar peers and it is hard to compare them with other small independents because they each have such unique assets and strategies. However, to put Ring Energy into perspective, I put them side to side with EOG Resources, the darling of independent exploration and production companies. The table below shows how REI measures against the much larger EOG. Ring Energy is obviously the more volatile of the two stocks, which is not a surprise, and should be a warning to investors who can’t stand volatility, but it also has comparable or better margins and a higher return on equity. None of these metrics imply that Ring Energy is a better company than EOG, but because of its smaller base and higher growth rate, I think Ring has much more upside than EOG in the long-run.

REI Peers

Wrap Up

Depending on your level of risk tolerance and whether you are more of a contrarian versus trend follower, I’ve given you several options for getting or increasing exposure to the energy sector. It may not be a smooth ride, but I believe that years from now we will all look back at this era and realize what a great time it was to invest in oil.

PM101

PM101

Investment Strategist at Portfolio Management 101
Patricia Moses has been managing investments since 2002 and has experience managing investments for individuals and institutions at all levels. She started her investment career in 1999 evaluating hedge funds and other alternative asset classes for a small regional investment consultant. After a brief time, she joined a family office as an Investment Advisor managing assets in excess of $300 million across a variety of asset classes.

Patricia joined Portfolio Management 101 in 2010 in a Portfolio Manager and Business Development role and became an Investment Strategist in 2014.
PM101
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